Chairman Grassley, Senator Baucus, Members of the
Committee, thank you for the opportunity to discuss a report that my office
is releasing today regarding the Internal Revenue Service’s administration
of certain employment tax laws.

The objective of our report
was to determine whether the existing tax laws, tax regulations, and IRS
policies and practices ensure fairness in the administration of
self-employment tax laws for similarly situated taxpayers. We compared the
employment tax liabilities of sole proprietors to the employment tax
liabilities of single-shareholder S corporations. Our report found that
employment tax inequities exist between sole proprietorships and
single-shareholder S corporations.

These inequities have historical underpinnings. In
1958, Congress established Subchapter S of the Internal Revenue Code, which
enabled small businesses, including sole proprietorships, to form
corporations owned by 10 or fewer shareholders. Electing S corporation
status exempts profits from corporate taxation and allows profits to “pass
through” to the shareholders. Shareholders are then responsible for paying
individual income taxes on the profits received. In addition, shareholders
who actively operate the business are subject to employment taxes on the
compensation received for their services.

The IRS developed its methodology for dealing with the
employment taxes of S corporations in 1959. This methodology does not
properly address how today’s S corporations are structured because the 1959
methodology is based on the assumption that S corporations will have
multiple shareholders or owners. In a multiple shareholder environment, a
consensus of shareholders typically set the salary of the business operator
at a level reflecting the market value of the operator’s services.

However, in Tax Year 2000, 78.9 percent of all S
corporations were either fully owned by a single shareholder, or more than
50 percent owned by a single shareholder. Therefore, in nearly 80 percent of
S corporations, the individual who owns the business determines the amount
of the salary paid to the shareholder operating the business.

The decision by the single shareholder of an S
corporation of what amount to pay himself or herself in salary has tax
consequences. A lower salary results in lower employment taxes and higher
profits. In comparison, sole proprietorships are treated much differently
for the purposes of employment taxes.

Employment taxes are authorized by the Federal
Insurance Contributions Act, or FICA, and the Self-Employment Contributions
Act, or SECA. FICA applies to S corporations, and SECA applies to sole
proprietors. Under FICA, S corporations are required to withhold taxes from
the wages of employees, with matching amounts paid by the employers. In
comparison, under SECA, sole proprietors must pay taxes on profits from the
operation of their businesses. The self-employment tax law treats all
profits (except for an amount equal to the employer portion of FICA) as if
they were wages. As a result, the sole proprietor pays the equivalent of
both the employer and employee portions of FICA on business profits.

The different tax treatment has caused the S
corporation form of ownership to become a multibillion dollar employment tax
loophole for single-shareholder businesses. For example, as shown in this
first chart, in Tax Year 2000, the owners of 36,000 single-shareholder S
corporations received no salaries at all from their corporations, even
though the operating profits of each of these corporations exceeded
$100,000. This resulted in employment taxes not being paid on $13.2 billion
in profits.

A 2001 tax court case provides a textbook example of
the type of S corporation shareholder I am referring to. A veterinarian was
the sole shareholder in his S corporation. His corporation produced over
$400,000 in total profits over three years. Yet, during these three years,
he declared no salary for himself, despite the fact that his corporation’s
sole source of income was from his services. In court, the IRS prevailed.
The tax court agreed that the corporation’s profits should be subject to
employment taxes.

Determining what is reasonable compensation to pay a
business officer is complex and subjective, and the IRS must sometimes
engage in litigation. Since the IRS is forced to address the issue of
reasonable officer compensation on a case-by-case basis, many owners of S
corporations have apparently determined that saving employment taxes by
minimizing salaries is worth the risk of an IRS examination. As shown in
the next chart, single-shareholder S corporations vary widely in the amount
of salary they give themselves. At the top of the chart, you can see that
many are willing to set their salaries at $0 to maximize their employment
tax savings.

Furthermore, the owners of single-shareholder S
corporations have been setting their salaries at a decreasing percentage of
corporate profits in the past several years. As shown in this third chart,
in Tax Year 1994, these shareholders paid themselves salaries subject to
employment taxes equal to 47.1 percent of their profits. This percentage
fell to 41.5 percent by Tax Year 2001. In comparison, sole proprietors pay
employment taxes on all their operating profits.

The employment tax consequences of these
single-shareholder S corporations paying themselves little or no salaries
are in the billions of dollars. My final chart compares the actual FICA
taxation of single-owner S corporations to the theoretical SECA taxation
that would have been paid if these profits were taxed as a sole
proprietorship. In Tax Year 2000 alone, S corporations paid $5.7 billion
less in employment taxes than would have been paid if the taxpayers were
sole proprietors.

Billions of dollars in Social Security and Medicare
taxes are being avoided by single-shareholder and majority-owned S
corporations. Trends indicate that the employment tax base is eroding. In
fact, advising small businesses to save on employment taxes by forming S
corporations has become a cottage industry. A search of the Internet yields
many sites that advise entrepreneurs that they can save thousands of dollars
a year in employment taxes simply by incorporating.

The Joint Committee on Taxation shares my concern about
the employment tax treatment of pass-through entities – such as S
corporations – and has recommended changes to their taxation. Additionally,
the Joint Committee outlined five general principles for improving
compliance and reducing the tax gap in testimony before this Committee last
month. The employment tax treatment of owners of pass-through entities was
included as one example of how compliance is hampered when tax outcomes are
dependent on difficult factual determinations.

Mr. Chairman and members of the committee, I appreciate
the opportunity to discuss this important issue. I look forward to working
with the IRS to identify and recommend solutions to this problem. I will be
happy to answer any questions you have at the appropriate time.Operating Profits of S Corporations That Paid No Salaries to the Sole
Owners (Tax Year 2000)